Investors Still Not Getting Breakpoints

Investment companies' new bright-line share class limits may not be enough to protect investors from mutual fund breakpoints sales abuse, according to a recent report.

Investors still may be overpaying due either to unscrupulous sales tactics or broker confusion about share class, according to the report by Morningstar of Chicago. To test the appropriateness of the A, B and C share classes under different investor scenarios, Morningstar created wealth simulations for 115,632 hypothetical mutual fund purchases in 803 mutual funds offering A, B and C share classes.

"There is a good chance that for every situation in which a rogue broker is manipulating share classes to exploit an investor, another investor is being overcharged because the bewildering maze of share class choices confused the broker," said Morningstar Vice President David McClellan. Even worse, he said, the very share class limits designed to protect the investor may force him or her into high-cost "A" shares.

Due to enforcement actions by the Securities and Exchange Commission, investment companies now require bright line share class sales limits. Under the rules, investors with $50,000 to $250,000 to invest may not be sold B share or C share classes because A share classes with breakpoints often result in lower sales commissions.

The rules are the result of a joint crackdown by the SEC and the NASD due to a number of financial advisers and brokers putting clients in B or C mutual fund share classes, which have higher annual charges. By contrast, A share classes, which levy the sales charge upfront, offer breakpoints that reward larger investors with lower fees. The NASD has conducted numerous "sweeps" of brokerage firms looking for these sales abuses, and has issued more than $50 million in fines and investor restitution since 2003.

With B shares, there are no front-end sales charges or breakpoints, but a contingent deferred sales charge that declines over time. B shares also have higher expense ratios than A shares. After eight years, B shares typically convert to A shares.

C shares have no front-end sales charges and typically have a small back-end exit charge during the first year. They have the same expenses as B shares, but C shares don't covert to A shares. As a result, C shares have high ongoing annual charges.

In addition to A, B and C shares, the Morningstar report said that many fund groups offer a confusing array of other share classes, along with multiple fee schedules.

Although the bright-line share class limits can help investors, they are not a cure-all. There are many situations in which multiple share classes are useful investment tools. For example, the Morningstar study, titled "Mutual Fund Share Class Limits and Share Class Suitability," found that A shares generally are best for investors who don't know how long they plan to invest and can achieve a breakpoint. But B shares often are a better choice for small investors who aren't investing enough to hit a breakpoint and don't know how long they'll invest. B shares typically outperform A shares over the short term and C shares over the long term, net of expenses.

According to Morningstar, C shares are best for those who invest for three years or less. They outperform A shares even with a breakpoint, as well as B shares. But there is no clear-cut winner for those investing for four to seven years.

A shares are the best choice for those who invest for at least eight years, but B shares may perform better for those with $50,000 or less to invest.

All the regulatory crackdowns, however, have had unintended consequences. Unfortunately, the way the system operates today, brokers can't follow Morningstar's advice due to the fact that broker/dealers have developed hard-and-fast rules that are more stringent than investment company bright-line breakpoint rules.

Research shows that the majority of brokerage firm mutual fund assets are going into just a few fund families that show the best overall fund track records, McClellan said.

"Many advisers feel pressured to consolidate clients' assets within a single fund family to take advantage of breakpoints," the report said. Nevertheless, some investors may benefit if their investments are diversified in different fund families that offer funds with better track records.

"Bright-line share class limits are best viewed as a starting point for share class suitability analysis," McClellan said. "But advisers should have the freedom to select any share class after carefully considering each investor's unique option."

Morningstar recommends that the brokerage and the mutual fund industries simplify the share class system. In addition, advisers should conduct a thorough analysis before deciding on the appropriate share class for their clients. They should not make their decision exclusively based on costs. Other important factors to consider include investment performance, diversification and the investor's time horizon.

Advisers should invest small accounts in B shares because their net returns are on par with A and C share classes. Because investments in the three-to-eight year time horizon are a grey area, advisers should evaluate the relative costs over different time spans to determine which share class delivers the best net returns.

On the broker/dealer side, Morningstar recommends raising the investment limit on C shares to $250,000, particularly for short- and intermediate-term time horizons.

Meanwhile, regulators need to be more flexible when it comes to breakpoint investment issues, according to Morningstar. The SEC and NASD need to remember that advisers are in the best position to help clients with their investment decisions, as long as they conduct a through analysis.

"Consider whether aggressive enforcement of bright-line share class limits are in the best interest of the investor," McClellan said. "Factors such as performance and diversification can trump cost savings when determining share class suitability."